Chap 13 - Real Estate Equity

Question 1

What are the typicall stages of creatinf real estate ?

Answer 1

(1) acquiring land or a site; (2) estimating the marketing potential and profitability of the development project; (3) developing a building program and design; (4) procuring the necessary public approvals and permits; (5) raising the necessary financing; (6) building the structure; and (7) leasing, managing, and perhaps eventually selling the property.

Question 2

What are the Two key factors differentiate development projects from
standing real estate investments ?

Answer 2

First, real estate development is a process in which a new asset is being created.

Second, during the lifetime of the development, there is a high degree of uncertainty regarding the estimates of the revenues and costs of the investment.

Question 3

What is a real option ?

Answer 3

Most real estate development projects may be viewed as a string of real options. A real option is an option on a real asset rather than a financial security. The real option may be a call option to purchase a real asset, a put option to sell a real asset, or an exchange option involving exchange of nonfinancial assets.

Question 4

What is Backward induction ?

Answer 4

Backward induction is the process of solving a decision tree by working from the
final nodes toward the first node, based on valuation analysis at each node.

Question 5

What is real estate valuation ?

Answer 5

In the context of commercial real estate analysis, real estate valuation is often used as a general term describing processes of estimating the worth of a property from various perspectives (especially the perspective of a financial analyst) with regard to the price at which informed investors would be willing to both buy and sell a property.

Question 6

What is a real estate appraisal ?

Answer 6

A real estate appraisal is generally viewed as a formal opinion of a value provided ban appraiser and often used in financial reports and in decision-making including lending. For institutional investors, appraisals are often performed once a year on real estate properties and are used in reporting.

Question 7

What are three major reasons for institutional focus on equity participations in commercial real estate ?

Answer 7

1. Most commercial real estate throughout the world is privately held rather than
   publicly traded (whether owned directly or held through limited partnerships).
2. Most of the equity of residential real estate is held by the occupier of the property
   rather than by an institutional investor.
3. The valuation of equity claims to private commercial real estate drives the pricing
   of the credit risk in the valuation of commercial mortgages. In other words, real
   estate debt may be viewed through the structural model (detailed in Level II of
   the CAIA program) as being well explained through an understanding of the
   risks of the equity in the same property (since assets equal debt plus equity).

Question 8

What are some approaches for valuing private commercial real estate ?

Answer 8

The comparable sale prices approach, the profit approach, the cost approach, the income approach, and multifactor transaction-based approaches.

Question 9

What is the comparable sale prices approach ?

Answer 9

The comparable sale prices approach values real estate based on transaction values of similar real estate, with adjustments made for differences in characteristics by a valuation professional such as an appraiser (real estate is unique). The approach tends to contain substantial subjectivity in the valuation of most characteristics other than the focal point (e.g., price per square foot).

The accuracy of the comparable sale approach (and other transaction-based approaches) is lower when there is a lack of frequency of property sales.

Question 10

What is the profit approach ?

Answer 10

The profit approach to real estate valuation is typically used only for properties with a value driven by the actual business use of the premises; it is effectively a valuation of the business rather than a valuation of the property itself. Thus the profit approach should only be used when the value of the property is based primarily on the value of the business that occupies the space.

Question 11

What is cost approach ?

Answer 11

The cost approach assumes that a buyer will not pay more for a property than it would cost to build an equivalent one. In this approach, a property’s value is initially based on its cost and can be further refined by adding the values of any improvements to the land value of the property and applying economic depreciation as appropriate.

Question 12

Cap Rate = NOI / Value (13.1) Where NOI is usually viewed on an annualized basis and represents the expected, normalized cash flow available to the owner of the real estate, ignoring financing costs (e.g., cash flows from rent, net of operating expenses). The variable “Value” used in Equation 13.1 is an estimate of the market value of the real estate on an unlevered basis.

Answer 12

Cap rates are often viewed as direct estimates or forecasts of expected returns or required returns.

Question 13

What is the income approach ?

Answer 13

The income approach values real estate by projecting expected income or cash flows, discounting for time and risk, and summing them to form the property’s total value and is similar to the discounted cash flow method (DCF method) used for valuing stocks and bonds.

However, it requires the estimation of an appropriate discount rate and is subject to forecasting errors of cash flows due to errors in forecasting occupancy rates, lease growth rates, expenses, the holding period for the property, the terminal value of the property, inflation estimates, etc.

Question 14

What are Transaction-based real estate valuation methods and why are they reliable ?

Answer 14

Transaction-based real estate valuation methods are based on relatively large data sets of actual transaction prices of properties within a specified time period and include the repeat-sales and hedonic methods.

Transaction-based methods can form a reliable basis for real estate valuation
when:

1. They are performed with adequate data and with rigorous econometric methods.
2. Differences among the properties are modeled well.
3. Statistical noise in the data is minimal.

Question 15

What are the 2 advantages and 4 Disadvantages of Appraisal-Based Models
over Transaction-Based Models ?

Answer 15

Advantages:
1. In general, they do not suffer from a small sample size problem.

2. All properties can be appraised frequently and by multiple experts, although this
   is a costly process.

Disadvantages:
1. Appraisals are inherently subjective and backward-looking, thus introducing
potential errors in the resulting valuation.

2. In the case of real estate price indices based on appraisals, not all properties are reappraised as frequently as the index is reported. This may cause a stale appraisal effect (i.e., errors from the use of dated appraisals), which contributes to the lagged recognition of price changes observed in appraisal-based indices.
3. Appraisal-based indices are smoothed compared with actual changes in real
   estate market values, meaning that substantial value changes tend to be reflected
   on a delayed basis. Thus, measures of volatility of the value of commercial real
   estate assets based on appraisal-based models are underestimated.
4. Appraisal-based methods tend to rely on data from comparable properties.
   Therefore, the quality of the appraisal will depend critically on the relevance
   and quality of available data.

Question 16

The National Council of Real Estate Investment Fiduciaries (NCREIF) is a large U.S. not-for-profit institutional real estate investment industry association that collects data from its members. The NCREIF Property Index (NPI) is a large, popular,value-weighted index published quarterly and is based on unleveraged commercial property appraisals (or leveraged data adjusted to an unleveraged basis).

Answer 16

The total return on the index is calculated as the sum of an income return and a capital value return. The income portion of the total return of each property is a fraction, with net operating income (NOI) in the numerator and an estimate of the
property value in the denominator. The capital value return is the change in the estimated value of the property from the beginning of the quarter to the end of the quarter, adjusted for capital improvements and partial sales such that increases in the value due to further investments are not included as profits, and declines in value due to partial sales are not deducted as losses.

Question 17

The calculation of the returns to the NPI is performed on a before-tax basis (and therefore do not include income tax expense) and is performed for each individual property and then value-weighted in the index calculation.

Question 18

DCF for income approach:
The net sale proceeds (NSP) is the expected selling price minus any expected selling expenses arising from the sale of the property at time T (last CF). Operating cash flows are usually estimated using the concept of net operating income. Net operating income (NOI) is a measure of periodic earnings that is calculated as the property’s rental income minus all expenses associated with maintaining and operating the property. Equating the expected cash flow at time t, E[CFt], with the net operating income, E[NOIt]

Question 19

For investors subject to income taxes, there are two ways to view income taxation. The pre-tax discounting approach is commonly used in finance, where pre-tax cash flows are used in the numerator of the present value analysis (as the cash flows to be received), and the pre-tax discount rate is used in the denominator. An alternative is to use an after-tax approach. In an after-tax discounting approach, the estimated after-tax cash flows (e.g., after-tax bond payments) are discounted using a rate that has been reduced to reflect the net rate received by an investor with a specified marginal tax rate.

Answer 19

Investment A offers $80 per year in taxable income and an additional final non taxable cash flow in five years of $1,000. An investor in a 40% tax bracket requires a pre-tax return of 8% and an after-tax return of 4.8% on investments. What is the value of Investment A on both a pre-tax basis and an after-tax basis? On a pre-tax basis, Investment A is worth $1,000, found on a financial calculator as PMT=$80, FV =$1,000, N =5,I=8%, solve for PV. On an aftertax basis, the $80 annual income is worth $48 [$80 × (100% – 40%)]. On an after-tax basis, Investment A is also worth $1,000, found on a financial calculator as PMT=$48, FV =$1,000, N =5, I=4.8%, solve for PV.

This ignored financing flows, such as interest payments and principal payments on a mortgage. The approach valued ownership of the entire real estate property as if there were no mortgage on the property. If there is a mortgage on the property, then the resulting value ($1,863,772) should be equal to the sum of the values of the property’s mortgage and equity.

Question 20

Valuation of the income approach may be viewed as having three stages: estimating the cash flows, estimating a discount rate, and calculating the value using the DCF method.

Question 21

What are Private equity real estate funds ?

Answer 21

Private equity real estate funds are privately organized funds that are similar to other alternative investment funds, such as private equity funds and hedge funds, yet have real estate as their underlying asset. Three specific types of private equity real estate
funds (commingled real estate funds, syndications, and joint ventures)

The funds follow active management real estate investment strategies, often including property development or redevelopment. Private equity real estate funds usually have a life span of 10 years: a two- to three-year investment period and a subsequent holding period during which the properties are expected to be sold.

The investor gains the possibility of investing in major real estate that would otherwise be too risky for him alone while getting expertise management on specific sectors (investor may lack knowledge). THE INVESTOR DOES NOT HAVE DIRECT CONTROL OVER THE REAL ESTATE

Question 22

What are Commingled real estate funds (CREFs) ?

Answer 22

Commingled real estate funds (CREFs) are a type of private equity real estate fund that is a pool of investment capital raised from private placements that are commingled to purchase commercial properties. The investors are primarily large financial institutions that receive a negotiable, although non-exchange-traded, ownership certificate that represents a proportionate share of the real estate assets owned by the fund.

Question 23

What are Syndications ?

Answer 23

Syndications are private equity real estate funds formed by a group of investors who retain a real estate expert with the intention of undertaking a particular real estate
project. A syndicate can be created to develop, acquire, operate, manage, or market real estate investments. Legally, real estate syndications may operate as REITs, as corporations, or as limited or general partnerships.

Syndicators profit from both the fees they collect for their services and the interest they may preserve in the syndicated property.

Question 24

In all of these investments vehicules the investors gains the opportunity to invest in real estate projects that would otherwise be outside their financial and management competencies.

Question 25

What are Real estate joint ventures ?

Answer 25

Real estate joint ventures are private equity real estate funds that consist of the combination of two or more parties, typically represented by a small number of individual or institutional investors. An example of a joint venture would be the case of an institutional investor with an interest in investing in real estate, but with no expertise in this area, that agrees to form a joint venture with a developer.

Question 26

What is gearing ?

Answer 26

Gearing is the use of leverage. The degree of gearing can be expressed using a variety of ratios. In real estate funds, a popular gearing ratio is the percentage of a fund’s capital that is financed by debt divided by the percentage of all long-term financing (e.g., debt plus equity). This ratio is often called the LTV (loan-to-value) ratio or the debt-to-assets ratio.

Ex: Private real estate fund A has $100 million of assets and $50 million of debt.
A is 50% debt, and has an LTV of 50% and a debt-to-equity ratio of 1.0.

Question 27

What are Open-end real estate mutual funds ?

Answer 27

Open-end real estate mutual funds are public investments that offer a non-exchange traded means of obtaining access to the private real estate market. Open-end funds initially raise money by selling shares of the funds to the public and generally continue to sell shares to the public when requested.

Question 28

What are stale pricing ?

Answer 28

The use of prices that lag changes in true market prices is known as stale pricing. Stale pricing of the net asset value of a fund provides an incentive for existing shareholders to exit (sell) during declining markets and new investors to enter (buy) during rising markets.

Question 29

In summary, investors in open-end mutual funds are typically offered daily opportunities to redeem their outstanding shares directly from the fund or to purchase additional and newly issued shares in the fund. This attempt to have high liquidity of open-end real estate fund shares contrasts with the illiquidity of the underlying real estate assets held in the fund’s portfolio. This liquidity mismatch raises issues about the extent to which investors will receive liquidity when they need it most and whether realized returns of some investors will be affected by the exit and entrance of other investors who are timing or arbitraging stale prices.

Question 30

What are closed-end fund is an exchange-traded mutual fund ?

Answer 30

A closed-end fund is an exchange-traded mutual fund that has a fixed number of shares outstanding. A closed-end real estate mutual fund is an investment pool that has real estate as its underlying asset and a relatively fixed number of outstanding shares.

They do not need to maintain liquidity to redeem shares, and they do not need to establish a net asset value at which entering and exiting investors can transact with the investment company. Unlike open-end funds, their existing shareholders are not disrupted by shareholders entering and exiting the fund, especially in an attempt to arbitrage stale prices –> shareholders buy and sell shares on secondary markets rather than affecting fund liquidity by redeeming shares or subscribing to new shares.

Question 31

What are Exchange-traded funds (ETFs) ?

Answer 31

Exchange-traded funds (ETFs) represent a tradable investment vehicle that tracks a
particular index or portfolio by holding its constituent assets or a subsample of them.

Question 32

The market returns on equity REITs have been observed to have a strong correlation with equity market returns, especially the returns of small-cap stocks (and to a slightly lesser extent those of mid-cap stocks).

The explanation that REIT returns are highly correlated with the returns of similarly sized operating firms due to the similarity of the risks of their underlying assets seems dubious.

Answer 32

Dividend yields on private REIT structures tend to be moderately higher than those on public REITs, suggesting that public REITs offer little or no risk premium for holding illiquid real estate.